Adelaide Brighton Needs To Re-Position

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Adelaide Brighton has slashed net profit estimates for 2019.  Brokers believe the housing market alone cannot be blamed.

-Structural change a significant component of the profit decline
-Caught wrong-footed with a lack of vertical integration in Queensland and Victoria
-Interim dividend suspended, brokers suspect final may also be at risk
 

By Eva Brocklehurst

A sombre outlook confronts building material supplier Adelaide Brighton ((ABC)), which has slashed its forecasts for the second time this year. A deteriorating housing market, competition and higher raw material costs remain the culprits.

The company has pointed out improved sentiment in the housing market is yet to translate into activity, and volumes are down by around -15%. Delays in infrastructure and non-residential projects have also frustrated activity.

Adelaide Brighton does not expect an upturn in the housing market to emerge for another 12-18 months. Underlying net profit is expected to be $120-130m, down 32-37% on 2018 and, for the first time in 20 years, the board has scrapped the interim dividend.

Macquarie finds the real challenge is in the positioning of the business in some markets, over and above the softening in market conditions. The broker concludes Adelaide Brighton is a victim of of stock-specific issues that are exacerbated by the backdrop, particularly in multi-residential construction.

The significant drop in profitability and coincidence of several factors signal to Credit Suisse a medium-term improvement could occur, but the company's commitment to preserve capital and "rightsizing" is inconsistent with the short sharp recovery that was priced into the stock since the first downgrade in May.

Management has attributed half of the latest downgrade to a deterioration in the market and half to company-specific factors. In Credit Suisse estimates, the specific factors do not explain half, which implies a larger decline in broad operating performance or perhaps "belated conservatism".

UBS asserts the commentary around reduced activity, increasing competition and falling pricing power should serve as a negative leading indicator for much of the building materials sector.

The broker believes the market is still adjusting to the known contraction in residential activity. Positive sentiment may have been building from an expected bottoming of housing approvals but the earnings outlook continues to be challenged.

Few of the issues appear to be easily solvable at any rate and the "good times are over", Morgan Stanley asserts, expecting the decline will likely continue into 2020. Structural change represents a meaningful component, particularly in South Australia, where the company has enjoyed favourable prices and margins, and, the broker argues, has been over-earning for a number of years.

Morgan Stanley believes the current 2019 price/earnings ratio of 18.3x is excessive and ignores the risks and high degree of uncertainty, downgrading to Underweight. Macquarie also downgrades, back to Neutral from Outperform, having foreseen some earnings risk, albeit the latest downgrade is greater than expected.

Ord Minnett now expects 2019 guidance can be achieved, assessing there is no sign of any near-term negative catalysts, raising its rating to Hold from Lighten. That said, the broker does not consider the stock "cheap". The main contributor to the decline, Ord Minnett believes, is the lowering of cement prices in South Australia, done to hold market share, estimating every -$10/t drop in the price in that state could have a -$7m impact on earnings (EBIT).

Specific Factors

The business model has been caught out by not being sufficiently vertically integrated in Queensland, sustaining a price squeeze in aggregates, Credit Suisse notes. This is also the case in Victoria, where it is vital to pick up infrastructure work. Meanwhile, cement prices have been pushed too far above import parity South Australia, where the company is undermined by a competitor entering the cement import market, attracted by high prices and profitability.

Adelaide Brighton lacks a strong infrastructure-oriented business which is a real problem in the current market, as infrastructure would help soften the impact of a slowdown in residential construction, Macquarie concurs.

Moreover, the lack of an integrated market position in Queensland in particular has meant the company is exposed to large increases in raw material prices at a time when the market dynamics have not been supportive. Despite the challenges, Adelaide Brighton continues to expand into the infrastructure market, targeting areas where it has operating advantages such as western Sydney.

Citi considers a Barro family takeover is the key risk to its Sell rating. The broker lowers its net profit forecast by -10-25% over 2019-21 on lower volume assumptions for cement, lime, concrete and aggregates and concrete products.

No Interim

While well within banking covenants, the interim dividend will be suspended in order to conserve capital and maintain balance sheet flexibility. This is a significant decision, in Citi's view. While including a final dividend for 2019, the broker has now removed any special dividends and acknowledges its assumptions may now be at risk.

Credit Suisse believes the decision to suspend the dividend is motivated as much by the unsustainability of the prior dividend and reduced profits as it is by the need to grow downstream. The broker, downgrading to Underperform, does not expect a final dividend in 2019 and expects a reduction to the 70% pay-out ratio subsequently, sufficient to fund $50m in acquisitions per annum.

FNArena's database has four Sell ratings and two Hold. The consensus target is $3.28, signalling -3.1% downside to the last share price. This compares with $3.94 ahead of the announcement. The dividend yield on 2019 forecasts is 2.5% and on 2020 5.3%.

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